* 1 Introduction
The Coca Cola Company (TCCC) is an American corporation and manufacturer especially known for its soft drinks like Coca Cola or Fanta. It sells over 3500 products, is available in over 200 countries and has revenues of nearly 50 billion us-dollars (Coca Cola Company, 2011). After Coca Cola was accused by the European commission (EC) to have abused its market power, Coca Cola gave in and set up commitments to prove that it does not abuse its power. They promised no exclusivity arrangements, no target or growth rebates, no use of its stronger brands to sell other less strong brands and finally a 20 percent free space in their coolers for other products and brands. These commitments were accepted by the EC. This essay explains why the EC is concerned about the abuse of market power and analyzes the commitments stated by the coca cola company in its economic terms and how they affect the market competition. Finally it will evaluate if the EC was correct in accepting these commitments.
Background to the Case
The EC tries to establish a free competitive market and a fair competition between businesses in setting up competition policies like state aid, merger control rules and antitrust also known as the European competition law (Report European Comission, 2010). It does so to ensure the maximization of social welfare which will be further explained in section 2. In September 2004, the EC started to proceed against the Coca Cola Company relying on their antitrust regulation. In October, 2004 Coca Cola was sent a “preliminary assessment” which stated the EC´s concerns about their abuse of market power. One month later Coca Cola submitted commitments in response to these Claims (European Comission, 2006).
The four commitments are as followed: 1. Coca cola promised that at all time their customers are free to buy or sell carbonated soft drinks from any supplier of their choice and therefore no more exclusivity arrangements; 2. No target or growth rates are allowed. Coca Cola no longer offers rebates that reward in purely purchasing the same amount or more of Coca Cola products than in the past. Hence it is easier for customers to purchase from other suppliers; 3. Coca Cola is not allowed to use its strong brand to push other products which are not that popular goods; 4. If Coca Cola provides free coolers to retailers, the retailers are allowed to use 20 per cent of its space for other brands and goods. If Coca Cola should break these commitments the EC could demand a fine of ten per cent of Coca Cola´s total worldwide turnover (European Comission, 2006).
Loss of Welfare due to Market Power
But why is the EC actually concerned about the abuse of market power, the ability of a firm to charge a price above marginal cost and earn a positive profit (Perloff, 2012), of big firms like TCCC? The main answer to this question is that the EC tries to ensure social welfare and to maximize it. But before answering this question social welfare needs to be elucidated. Social welfare itself is difficult to measure. One way to measure it is to define it as the sum of the consumer and producer surplus. Perloff describes the consumer surplus as: “The monetary difference between what a consumer is willing to pay for the quantity of the good purchased and what the good actually costs” (Perloff, 2012). In other words the consumer surplus is used to measure and compare consumer welfare, the benefit of a certain product a person gets consuming that product less the money he or she paid for the good. In contrast the producer surplus is described by Perloff as followed: “The difference between the amount for which a good sells and the minimum amount necessary for the seller to be willing to produce the good” (Perloff, 2012).
It is the gain of trade and thus equal to the profit from trade minus the profit from not trading. The EC tries to maximize the social welfare. This is only possible in a competitive market because in such a market environment the price equals the marginal costs (Perloff, 2012) which results in an equilibrium price, an economic term for a balance between the wants of producers and consumers and no loss of welfare. However, the converse argument is that in a non-competitive market social welfare is not maximized. The biggest counterpart to a free competitive market is a monopolistic market. Although TCCC is not a real monopoly it has big market power and can therefore be compared to a monopoly. The loss of social welfare, the deadweight loss, which occurs if a monopoly (or a company with a big market power) arises, is shown in Figure 1.
Figure 1 Deadweight Loss of Monopoly 1 (Barnett, 2007)
Figure 1 shows that at the competitive equilibrium the price (Pc) is lower than the monopoly price (Pm) and the quantity (Qc) is bigger than the quantity (Qm) which the monopoly supplies. Hence a deadweight loss arises. This deadweight loss develops only due to missing competition. This scenario could appear due to an abuse of market power. By definition, market power is the ability to charge a price above marginal cost and therefore earn a positive profit (Perloff, 2012). Compared to a competitive market the demand curve is not horizontal but downwards sloping. This means that although the quantity decreases if a monopoly raises its price there are still buyers for the product. In a competitive market this is not true because the demand curve is horizontal and only the slightest increase in price will result in zero demand. As we can see in Figure 1: The monopoly is able to set its price not at the equilibrium (the intersection of marginal cost and the market price) but at a point at which it maximizes its own profit (a point where the price is higher than marginal costs).
This results in a welfare loss for the consumers which the EC tries to prevent. Furthermore the market power is related to the shape of the demand curve and tells a monopoly how much it can raise its price above the competitive equilibrium (the interception with the marginal cost) at the profit maximizing quantity. The more elastic the demand curve becomes, graphically this would means a nearly flat curve, the more sales are lost even if the price is only slightly increased. Conversely, if the demand curve is a steep curve (not very elastic) it would lose fewer sales by the same increase of price (Perloff, 2012). However a firm with a big market power or a monopoly benefit from large economies of scale. They can produce their products cheaper than any number of other firms together and for this reason not challengeable (Perloff, 2012).
Economic Effect of the Commitments on Market Competition
Concerned of the big market power TCCC had, the EC decided to intervene and requested Coca Cola to come up with solutions to allow the free competition to grow. Coca Cola then set up four commitments which were accepted by the EC. Although all four head to the same economic effect of lowering entry barriers for competitors and accordingly make consumers more aware of substitutes for Coca Cola products, all four are described separately. The first commitment assured that TCCC would not accept any exclusivity arrangements. It allows customers of Coca Cola to sell any soft drinks from any supplier next to Coca Cola. This means more suppliers which results in more products similar to Coca Cola´s products, substitutes. Although these substitutes existed also before the commitment it is now much easier for consumers to be aware of these and accordingly buy these. The economic effect of more substitutes was already explained in section 2: The market power is related to the demand curve. The flatter the demand curve is the more elastic it is and therefore a small increase in price leads to a big loss in sales. If we now take the substitutes into account the demand curve of TCCC becomes more elastic because consumers can choose between products of different suppliers.
Hence Coca Cola cannot set its price per unit as high as before. In other words the demand curve gets closer to a competitive demand curve and if TCCC sets its prices too high consumers will buy a substitute. In addition as prices of Coca Cola´s products gets lower it becomes easier for other firms to enter the market. The second commitment prevented Coca Cola to set up target or growth rates. Hence Coca Cola was not able to reward customers for purchasing the same amount or more of Coca Cola products than in the past. Again this makes it easier for customers to buy from other soft drink suppliers or a less amount of Coca Cola products plus different products. Economically this has the same effect as the first commitment and concentrates the overall effect: The demand curve becomes even more elastic and the market becomes more competitive. The third commitment states that TCCC is not allowed to use the strongest brands to sell less popular brands.
Again consumer can choose more easily between different suppliers and the competition in the market is further increased. Next to this economic effect it is now harder for Coca Cola to sell its less popular products and weakens its market power and brings TCCC even closer to sell at the competitive equilibrium. Secondary to the economic effect of the more elastic demand curve the decrease of entry barriers and the gain of substitutes increase the supply of the market. As more suppliers enter the market, supply increases which lowers the price of products in the market. The last commitment allows retailers to use 20 percent of the space in the Coca Cola coolers although they were provided by TCCC for free.
Therefore Retailers who want to benefit of a free cooler are not forced to use it only for Coca Cola products anymore. This makes it easy for consumers to be aware of substitutes of Coca Cola´s products as well as comparing prices. All in all the four commitments are heading to decrease TCCC´s market power and to increase the competition in the market. They do so allowing substitutes gain more attention by customers which results in a more elastic demand curve for Coca Cola. The more elastic it becomes the more competition increases in the market. Moreover the market´s supply increases and prices decrease.
Finally it can be said that firms with too much market power can reduce the social welfare. In order to protect this social welfare the EC accepted the four commitments. The closer analysis of the four commitments and their economic effect on the market shows that due to lower entry barriers the market´s supply is increased and more substitutes are easier available for consumers. In addition, Coca Cola´s demand decreases and it cannot benefit from its economies of scales as it could before.
Furthermore, it cannot set its price as high as it could before. Although Coca Cola does not lose all of its market power and is still one of the biggest companies and soft drink suppliers worldwide its market power is reduced by the EC´s actions and this results in an increase of market competition and a reduction of Coca Cola´s market power. If it was actually maximized to its fullest cannot be said because the information of actual demand or marginal cost curves is always limited, nor are the theoretical assumptions of a market environment given in real life. Nevertheless, the social welfare was definitely increased by the EC and therefore it was right to accept the four commitments.
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Perloff. (2012). Microeconomics. England: Pearson.
Report European Comission, C. (2010). Report on competition policy . Brussels.